Ratio Analysis is the most common tool for analyzing financial statements and what they can tell us about a business. Ratio Analysis starts with the business’s (presumably) accurate financial statements. Those statements provide an accounting picture of the operations (for a period) and the financial position (at a point in time).
While financial statements are historical, they can be used to project and predict the future. Ratios are designed to highlight meaningful relationships among financial data.
Ratios can be based on a comparison of industry norms, reveal trends over time or allow for management to evaluate operations.
There are dozens of ratios in usage and an unlimited number can be devised. They are generally classified into eight categories:
- Liquidity (the nearness to cash of assets and liabilities).
- Activity (asset management).
- Profitability.
- Coverage (the ability to cover certain charges).
- Debt management.
- Operating and financial leverage.
- Market value or per share information.
Liquidity ratios include the Current Ratio (Current Assets/Current Liabilities) and the Quick Ratio (Cash + Marketable Securities + Receivables/Current Liabilities). The higher the number the better.
Activity ratios measure how efficiently assets are used. The Inventory Turnover (Cost of Good Sold/Average Inventory) and Accounts Receivable Turnover (Credit Sales/Average Accounts Receivable) are the most common. The more “turns” per period, the better. Inventory and Receivables are also commonly stated in the number of days’ sales in the ending inventory and the number of days’ sales in AR. In both cases, the lower the number of days, the better. These can be combined in the Number of Days in the Operating Cycle. This is, the cash-to-cash cycle of the business. The shorter, the better.
Profitability Ratios include the Gross Margin percentage and the Net Margin percentage. Gross margin is probably the best expression of your value proposition. The net margin is “the bottom line”; after everything.
The most common Coverage Ratio is the Times Interest Earned ratio. This is EBITDA/Interest. The higher the better.
For Debt Management (leverage) ratios, the Debt to Equity ratio is most common. The lower the better in this case because it means less risk. However, remember that debt is usually the cheapest form of capital and leveraging equity will provide a greater return on owners’ equity.
Operating and Financial Leverage ratios are rarely used for small to medium-sized businesses. Suffice to say that they measure operating leverages rather than financial leverage.
Market Value and Per Share information are commonly used for bigger businesses. But some of these are relevant to smaller firms too. For example, public companies are often measured by their P/E or Price/Earnings ratio (Stock Price per share/Earnings per share). Real estate is usually valued by the capitalization rate, which is similar to the P/E ratio: Net Operating Income/Market Value. And when you go to sell your small business, the value is usually two to five times net income.
So what are the best ratios to use to monitor a business? Unfortunately there are no easy answers. It depends on the circumstances and the preferences of the person doing the monitoring. That might not be the most satisfying answer, but financial analysis remains as much art as science. My best advice is consult your trusted financial adviser to determine which to use.
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